Credit Leverage Running Out at Community Banks

Community banks are on the verge of losing a powerful weapon in their battles to bolster the bottom line.

Management teams were particularly aggressive in reducing loan-loss provisions last quarter. As a result, it could become more difficult to boost profit in coming quarters by reducing provisions.

The average fourth-quarter loan-loss provision fell nearly 30% from a quarter earlier and 36% from the fourth quarter of 2011, according to an American Banker analysis of reports from more than 100 banks with assets of $35 billion or less.

Loan-loss reserves soon will reach a point of equilibrium with the overall size and risk profile of banks’ loan portfolios, neutralizing the industry’s ability to cut credit costs.

As those opportunities wane, investors will likely gravitate more toward banks that can cut costs elsewhere, book loans and increase fee revenue to maintain earnings momentum. Those metrics will become increasingly critical in determining the industry’s winners and losers.

"The credit story has about run its course," says Jeff Davis, a managing director of financial institutions group at Mercer Capital. "There are another few quarters that credit can improve … but investors are beginning to focus on real revenue growth."

"For the most part, credit leverage has played out," David Bishop, an analyst at Stifel Nicolaus, said in a recent interview. "There are some outliers, but not many earnings levers remain" when it comes to reducing credit-related expenses.

A handful of community banks went a step further by drawing down their loan-loss allowances during the fourth quarter, including Wilshire Bancorp (WIBC) and PacWest Bancorp (PACW), which are in Los Angeles, and Boston Private Financial Holdings (BPFH) in Boston.

Improving credit quality and the pending sale of branches in Seattle prompted a provision credit at Boston Private, Dave Kaye, the company’s chief financial officer, said during a Jan. 17 conference call.

Executives at Wilshire said during a Jan. 24 conference call that it was too early to determine if they would make similar moves this year.

"We do see some of the stabilization in our market," Alex Ko, Wilshire’s chief financial officer, said. "But this is January. It’s premature to tell. … We are paying extra attention to this matter."

The good news about the trend is it means that credit quality, for the most part, continues to improve. So far, banks seem to have avoided a repeat of the underwriting mistakes that created the last credit crisis.

Average nonperforming assets at Dec. 31 among the banks reviewed by American Banker declined 5% from Sept. 30 and 15% from a year earlier. The ratio of nonperforming assets to total assets at those banks fell to 1.54% in the fourth quarter, down from 1.66% in the third quarter and 2% a year earlier.

And bankers are charging off fewer bad loans; average net chargeoffs dropped 20% from the third quarter and nearly 40% from a year earlier.

Of course that could quickly change, if bankers get antsy to book more loans to offset net interest margins that continue to shrink.

It is "important that banks avoid taking on risky assets again," warns Frank Barkocy, the director of research at Mendon Capital Advisors.